The Lowell Sun article

Here is a new link to my interview in The lowell Sun newspaper (9/2/07)

http://rishisondhi.googlepages.com/LowellSunarticle.pdf

Margin of Safety

According to Warren Buffett, the two rules of investing are:

• Rule No. 1: Never lose money
• Rule No. 2: Never forget Rule No. 1

As an individual investor who started investing just before the dot com bust, I have learned this the hard way but now these tenets are instilled in me.

Warren Buffett’s teacher and father of value investing, Ben Graham, first coined the "margin of safety" expression in his classic text, The Intelligent Investor. In investing, trends come and go all the time. However, these words have stood the test of time. Even today, Warren Buffett calls them "the three most important words in all of investing."

The beauty of value investing is in its simplicity. All one has to do is:

1. Calculate the intrinsic value of a company.
2. Buy the stock if it can purchased at a suitable margin of safety compared to its intrinsic value.
3. Wait for the market to correct the stock price.
   

[The intrinsic value of an investment is determined by discounting the future cash flows of an investment by an appropriate interest rate. I personally use DCF analysis.]

While this approach is painfully simple, it is difficult to follow. The main reason is that since every investor has to make assumptions to calculate this value, the estimates can vary widely. This is where margin of safety comes in. Ben Graham used a 33% (one-third) margin of safety compared to the book value when looking for potential investments. Other value investors have a different hurdle rate. The bottom line is: the wider the margin of safety, the better it is. To paraphrase Buffett, “You build a bridge that can withstand 30,000 ton trucks but insist that only 10,000 ton trucks drive on it”.

The more I thought about this, the more it made sense. As an engineer designing complex technical solutions, I was using margin of safety everyday. When working on industrial applications, I would scale up the pilot test data to design production scale systems incorporating a safety factor or scale-up factor: this is exactly the concept of margin of safety!

Margin of safety protects us from the whims of the market and minimizes the risk of permanent loss of capital. There are two main benefits:

1. Lets say you made an investment in a company that was selling at a 40% margin of safety. Suppose there is a change in the company’s business or if your assumptions were not as accurate, and the new margin of safety is 20%. You are still protected and can wait for your thesis to play out.
2. The other advantage is the higher upside potential. Suppose your original thesis was sound and you were able to purchase the company at a 40% discount. Just because the market restores the company price to match its intrinsic value, your investment will have a 66% return!

Of course, having a disciplined strategy is easier said than done. Even if you apply a margin of safety in your purchase decision, any subsequent decrease in price may be difficult on your system. This is where your temperament comes in. Ideally, any change in price should be considered as an opportunity to buy, sell or hold that investment. In other words, look at it as if you were approaching it for the first time.

In the end, it takes discipline to apply the margin of safety and courage to stick with your investments when the gusts are blowing in your face.

Lowell Sun newspaper article

Please checkout my interview in the Lowell Sun newspaper about my interest in investing and the investing seminars that I am organizing with the help of Chelmsford Public Library.

http://www.lowellsun.com/business/ci_6786395

Stocks: The Best Investment Vehicle?

One of the ongoing debates in the world of personal finance is what is the best investment option: stocks, bonds, treasuries or commodities? The answer, I believe, depends on personal risk-tolerance and circumstances. For money that is needed for at least five years, the best option may be an intelligent investment in the stock market.

Perhaps the most comprehensive evidence I have seen is the research by Wharton Professor, Dr. Jeremy Siegel. In his book, Stock for the long run, Prof. Siegel compares the returns of different assets over the last two centuries (yes, you read that correct). See below Table.

Time: 1802 - 2001
Not adjusted for inflation
Stocks: $8.8 million
Bonds: $13,975
Bills: $4,455
Gold: $14

Adjusted for inflation
Stocks: $599,605
Bonds: $952
Bills: $304
Gold: $1


Stocks beat the pants off all other investments over the same time. Its not even close!

Critics will say that average investor does not invest for 200 years. Fair enough.
But research has shown that even for shorter periods like 5 to 10 years, stocks still outpace the other investments on average even though there may be periods of under performance.

Additionally, people correctly point out that real estate was not included in the above comparison. Investment in real estate is easier than ever with REITs (Real Estate Investment Trusts), which can be bought and sold like stocks. Another advantage of real estate is the extended returns one can achieve with leverage.

Jack Clark Francis at Baruch College, New York City, and Roger G. Ibbotson at Yale University compared real estate with 15 different "paper" investments – stocks, bonds, commodities and real estate investment trusts (REITs) from 1978 to 2004. They reported the following returns:

• Housing – 8.6%.
• Commercial property – 9.5%.
• The S&P 500 (proxy for stocks) – 13.4%.

In spite of the strong housing market of the last 2 decades, stocks still came out ahead. Additionally, stocks have several advantages – better performance, low costs, diversification and amount of effort needed by the investor - compared to real estate. The recent downturn in the housing market has shown us how difficult it is for some homeowners to sell their house in a down market.

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Time to take charge

Wake up Call

One would think that in today's society, which encourages putting self before others, everybody would make their finances the top priority. The truth, however, is that we are not financially prepared. In my earlier post, I had listed some of the reasons why the individual investor is not financially savvy.

In this post, I would like to talk about the reasons why we need to take charge of our finances:

Retirement

• According to the Employee Benefits Research Institute (EBRI) 2007 Retirement Confidence Survey, nearly 50% people have less than $25,000 saved!
• Many companies are discontinuing defined benefit plans (pension plans) and moving to defined contribution (401k plans).
• Individuals are responsible for their retirement accounts. Individuals need to be aware of different fund types (equities, income and sector funds), asset allocation and expenses among other things.
• Social security system may not be solvent when we retire.

Health care

• Health care and medical insurance costs , which have been steadily increasing, are expected to be majority of the retirement spending.
  

Negative savings

• We spend more than we earn. According to latest savings survey, national saving rate is -1% ! You do the math - I do not need to add anything here except that we should not forget the "Live Below Your Means" mantra.
  

Education costs

• College costs are increasing faster than inflation rate. For some of the top schools in the country, annual tuition and boarding costs are ~$40,000. Do you have enough money saved for junior's Ivy League education?

Estate Planning

• If you are lucky to leave a legacy behind, you need to establish the right trusts and estates to provide for your family and take care of other goals like charitable donations. According to some estimates, probate and estate settlement costs (a.k.a death taxes) can be up to 10% of your estate.
  

Fun money

• This is how we pay for the fun stuff - vacations, second home, cars, big screen TV, etc. While we like to splurge on vacations and toys, it makes sense to plan for such purchases so our saving plan doesn't derail.
  
  
  

Book Review: The Little Book of Common Sense Investing

The Little Book of Common Sense Investing
By John Bogle



This is the latest book in the Little Book Big Profits series.
As much as I'm a big fan of value investing and enjoyed the earlier books in this series (The Little Book That Beats the Market by Joel Greenblatt and The Little Book of Value Investing by Christopher Browne), John Bogle makes a very compelling argument in favor of passive investing. I have to agree with Mr. Bogle and I personally follow an "index funds plus a few stocks" philosophy. As I hone my investing skills, individual stocks will be a greater percentage of my portfolio but foe now, I'm a firm believer in index funds and ETFs.



Anyway, onwards we go...



Main point of the book:

• Beating the market before costs and expenses is a zero sum game, while


• Beating the market after costs and expenses is a loser's game

Tyranny of Costs

• On average, the typical cost of fund ownership is 3% to 3.5%.


• Assuming a 8% average return of stock market and 5.5% return on typical fund, a $10,000 investment in a index fund will grow to $469,000 while the same investment in the typical managed fund will grow to $145,000- resulting in a shortfall of $323,600!


• The real return of a typical managed fund is even worse because of higher turnover (portfolio churning) which means higher capital gains taxes for fundholders.

Are fund managers and investment advisers smarter than the average investor?

• Out of the 355 mutual funds started in 1970, only three funds, or 8/10 of 1%, have beaten the market!


• A recent study found that average return of funds recommended by advisor was 2.9%. Average return of funds selected directly by investors - 6.6%

A good rule of thumb

• Transaction costs of a fund average about 1% of the fund turnover rate. For example, a fund with 100% turnover would carry a cost of 1% of assets. This is important fact generally overlooked by fundholders since it is not disclosed by the fund companies and difficult to find.

An interesting thing about the book is that Bogle brings up Buffett and Graham as proponents of index funds while these two individuals have been called the founders of value investing! While it is true that Buffett has endorsed index funds for the "know nothing" investor, he has also said that for a "know something" investor, it makes sense to buy fractional ownership stakes (a.k.a shares) of wide-moat companies selling at reasonable prices compared to their intrinsic values.

The above issue notwithstanding, this is a great book and I recommend it to everybody.

For another excellent take on the book, check out...

http://www.fool.com/investing/value/2007/07/02/the-little-book-of-common-sense-investing.aspx?vstest=search_042607_linkdefault